Wall Street Journal:  Consumer Groups Push Tax Relief for Homeowners in Bailout, by Ruth Simon:

Consumer groups are pressing Congress to extend tax relief to a broader group of troubled homeowners as part of any financial industry bailout plan.

Homeowners can incur a tax bill if the mortgage company reduces their loan amount, forecloses on the home or agrees to a short sale, a transaction in which the borrower sells the home for less than the amount owed, with the lender generally forgiving the difference.

Last year, under the Mortgage Forgiveness Debt Relief Act of 2007, Congress gave a tax break to certain homeowners whose mortgages were reduced by their lenders, relieving some already troubled consumers from going deeper into debt trying to pay off a large and unexpected tax bill. But the measure generally didn’t extend to any increase in the mortgage balance when borrowers refinanced their mortgages. Consumer groups say that was a major oversight that needs to be corrected. …

Under current law, borrowers don’t have to pay any tax if forgiven mortgage debt was used in "acquiring, constructing or substantially improving" their home, provided that the home is their primary residence, said Deborah Geier, a professor of law at Cleveland State University. But they can face a tax bill if the forgiven debt was used for other reasons, unless the person is insolvent, in bankruptcy court or eligible for certain other exclusions.

Prof. Geier said that the bill passed last year made sense "because homes are losing value not because of personal consumption by the taxpayer, but because of market fluctuations." But extending tax forgiveness more broadly "would be a back door for people who own homes to fund personal consumption with tax-free dollars." Borrowers don’t get tax forgiveness if auto or credit card debt is wiped out, she said, unless they are insolvent or in bankruptcy court.